Chapter 5

project management and resource allocation:

✓Basics of Project Management,
✓Work breakdown structure;
✓Project organization,
✓Network scheduling;
✓Resource allocation.
 What is a Project?
✓“Unique process that used to
Temporary
achieve an objective conforming Endeavour
to specific requirements”.
Project: Define
Several
✓ is a planned set of activities Phases Project Beginning
and End
✓has a scope
✓has time, cost, quality and
resource constraints Unique output
 What is a Project?

A Project
is a conversion
process
 Project Performance Dimensions
Thus, the performance of a project is measured by the degree
to which these three parameters (scope, time and cost) are
achieved.
Mathematically
Performance = f (Scope, Cost, Time)

Any increase in the scope of work requires a corresponding increase in budget and schedule.
Conversely, any decrease in scope of work results in a corresponding decrease in budget and
schedule. This principle applies between any and all of the three components of a project. For
example, any adjustment in budget and/or schedule requires a corresponding adjustment in scope.
This simple concept of a balance between scope, budget, and schedule is sometimes not fully
recognized during early project development as well as during design and construction.
 Types of Projects
There are three broad categories of projects to consider: Strategic
Projects, Operational Projects, and Compliance Projects.

I. Strategic Projects
✓involve creating something new and innovative.
✓A new product, a new service, a new retail location, a new branch or
division, or even a new factory might be a strategic project, because it will
allow an organization to gain strategic advantage over its competitors.
 Cont….
II. Operational Projects
Such project types required to improve current operations.
These projects may not produce radical improvements, but they will
reduce costs, get work done more efficiently, or produce a higher quality
product.
III. Compliance Projects
✓This project must be done in order to comply with an industry or
governmental regulation or standard.
✓Often there is no choice about whether to implement a project to meet a
regulation, but there may be several project options to consider, any of
which would result in meeting compliance requirements.
 Life cycle of a project

1. Project Selection
1. Selection of Project
consideration
2. Project Planning • Receptive to new ideas
• Vision of future growth
3. Project Implementation
• Long-term objective
4. Project Completion and Audit • SWOT analysis
• Preliminary project Analysis
➢ Project Selection Criteria: 3. Project Implementation
✓Organizing team and work
➢Investment business
✓Clear Cost/Time/performance goals
➢Rate of return ➢Expected life
➢Risk ➢Flexibility ✓Project Monitoring with regard to
➢Likely profit ➢Environmental Impact cost/value of work and time
➢Payback ➢Competition ✓Project Control
➢Similarity to existing

2. Project Planning 4. Project Completion

• Forming a project team with leader
• Defining scope and terms of ✓ Disbanding of project team
reference
• Work break down structure ✓ Handing over of project to user
• Basic scheduling
✓ Accounting and project reporting
• Time cost tradeoffs
• Resource Considerations ✓ Learning from experience
 WHY DO PROJECTS FAIL?

1. Poor project and program management discipline

2. Lack of executive-level support
3. Wrong team members
4. Poor communication
5. No measures for evaluating the success of the project
6. No risk management
7. Inability to manage change
Project Management….

Work Smart Not Hard !!!

 What Project Management do?

The art of organising, leading, reporting

and completing a project through
people .

Definition:
“The application of knowledge, skills, tools
and techniques to project activities in order to
meet the defined project requirements.”
 Cont…
“Project management is the planning, organizing, directing,

and controlling of company resources for a relatively short

term objective that has been established to complete

specific goals and objectives.”

Harold Kerzner, Project Management, pg. 4

Work Breakdown Structure (WBS)
 Work Breakdown Structure (WBS)

❖ Process of subdividing project deliverables and project work into

smaller, more manageable components

❖ The technique of breaking down the total work into more manageable

chunks is called decomposition.

❖ The WBS is a communications tool, providing detailed information to

different levels of management.

 Advantages Disadvantages.
✓Easier monitoring of work
✓ Requires active management of
definitions
✓Coherent delegation interfaces
✓Progressive work management ✓ Increased work burdens on
✓Constant improvement of management and management
processes
functions like planning, organizing,
✓Risk management
monitoring, and review
✓Training systems
✓Planning evaluation ✓ Potential delineation problems
 Example1: work breakdown for painting a room
1. Prepare materials
1.1. Buy paint
1.2. Buy brushes/rollers
1.3. Buy wallpaper remover
2. Prepare room
2.1. Remove old wallpaper
2.2. Remove detachable decorations
2.3. Cover floor with old newspapers
2.4. Cover electrical outlet swith tape
2.5. Cover furniture with sheets
3. Paint the room
4. Clean up the room
4.1. Dispose left over paint
4.2. Clean brushes/rollers
4.3. Dispose of old newspapers
4.4. Remove covers
Project Planning
and
Scheduling
 Drawing the network
• Network diagrams are used to show complex relationships between
activities.

• Technique for graphically displaying the logic of scheduled activities

using boxes and arrows.

• The boxes in this type of diagram are called nodes and the arrows
indicate finish-start relationships.

• The purpose is to visually depict the types of relationships between

components.
 Drawing network Diagram
Network diagram – diagram of project activities that shows sequential
relationships by the use of arrows and nodes.
Activity-on-arrow (AOA) – a network diagram convention in which arrows
designate activities.
Activity-on-node (AON) – a network diagram convention in which nodes
designate activities.
Activities – steps in the project that consume resources and time.
Events – the starting and finishing of activities, designated by nodes in
the AOA convention.
 Compression between AOA and AON
Meaning Activity on nodes Activity on arrows
A B
A comes before B A B 1 2 3

1
A
A and B must be A C
C 3 4
finished before C
B
started B
2

B 3
B
A must be finished A
A 1 2
before started B C
C
and C 4
 Compression between AOA and AON
Meaning Activity on nodes Activity on arrows
4
A C
1 C
A and B must be A
finished before C 3
D
B
and D started B D 2 4

A C
1 4 6
A C
A and B must be
finished before C
and D started after B D
B D
B is completed. 2 3 5
Dummy are introduced
 A Comparison of AON and AOA Network Conventions
Meaning Activity on nodes Activity on arrows

B and C cannot begin

A B D
until A is completed. D A B D 1 2 4 5
cannot begin until both Dummy C
B and C are completed. activity
C 3
A dummy activity is
again introduced in AOA.
 Constructing error in network diagram
3
To ensure this its
Two activities start from tail batter to introduce
event must not have the same dummy activity 1 2
head event
In network only one starting and
1 2 one ending event for arrow

Loping error must be avoided in network construction

3
Avoid mixing arrows in network
In network the arrow must drawn from
1 2 left to right
 CPM (Critical Path Method) evolutions
• CPM was the discovery BY Walker and Remington in 1957 and

tested in 1958, when it was applied to the construction of a

new chemical plant.

• In March 1959, the method was applied to maintenance shut-

down and reduced Unproductive time from 125 to 93 hours.

 CPM Definition
• The critical path is a set of activities that have no slack.

• Ever network diagram have at least one critical path.

• A critical path is the longest path in the network.

• The sum of the completion times for the activities on the critical path is
the minimal completion time of the project.

• CPM Is a techniques used to analyzing, planning and scheduling activity

• CPM Helps to see total completion time of project

Example 1
Activity Duration
Determine the early start 1-2 6
2-3 4
and late start in respect of
2-4 9

all node points and 2-5 2

3-5 7
identify critical path for 4-5 8
5-6 5
the following activity
Activity Duration ES EF LS LF slack

1-2 6 0 6 0 6 0
2-3 4 6 10 12 16 6
2-4 9 6 15 6 15 0
2-5 2 6 8 21 23 15
3-5 7 10 17 16 23 6
4-5 8 15 23 15 23 0
5-6 5 23 28 23 28 0
From the table, the critical nodes are (1-2), (2-4),
(4-5), and (5-6)

Therefore, the possible

critical path is
1→2→4→5→6
 Critical Path Method – exercise
A project schedule has the following characteristics as shown in Table

I. Construct network diagram

II. Determine PERT.
III. Compute slack for each activity.
IV. Find the critical path.
PERT (Project Evaluation and Review Technique)
PERT was devised in 1958 for the POLARIS missile program by the
Program Evaluation Branch of the Special Projects office of the
U.S by Allen & Hamilton.
PERT is used for multiple time estimates which have probabilistic
activity times
Used for non-repetitive jobs (research and development work),
where the time and cost estimates tend to be quite uncertain.
 PROJECT EVALUATION REVIEW TECHNIQUE, (PERT)
Optimistic time tO:
• It is the shortest time taken to complete the
activity. It means that if everything goes well
then there is more chance of completing the
activity within this time.
Most likely time tm:
• It is the normal time taken to complete an
activity, if the activity were frequently
repeated under the same conditions.
Pessimistic time tp:
• It is the longest time that an activity would
take to complete. It is the worst time
estimate that an activity would take if
unexpected problems are faced.
 PROJECT EVALUATION REVIEW TECHNIQUE, (PERT)

• Taking all these time estimates into consideration,

the expected time of an activity is arrived at.

• The average or mean (ta) value of the activity

duration is given by, The variance of the activity time
is calculated using the formula,
 PERT- Example
• An R & D project has a list of tasks to a. Draw the project
be performed whose time estimates
are given in the Table , as follows. network.
b. Compute PERTs
Activity To Tm Tp
1-2 4 6 8 c. Find the critical path.

2-3 2 3 10 d. Calculate variance and

2-4 6 8 16 standard deviation for
2-5 1 2 3 critical path.
3-5 6 7 8 e. Find the probability of
4-5 6 7 14 completing the project at
5-6 3 5 7 32 days
a. Draw the project network.
b. Compute PERTs
• Time expected for each activity is calculated using the
formula : Similarly, the expected time is calculated for all
the activities.
Activity To Tm TP TE ES EF LS LF slack
0 6 0 6 0
1-2 4 6 8 6
6 10 12 16 6
2-3 2 3 10 4
6 15 6 15 0
2-4 6 8 16 9
6 8 21 23 15
2-5 1 2 3 2
10 17 16 23 6
3-5 6 7 8 7
15 23 15 23 0
4-5 6 7 14 8
23 28 23 28 0
5-6 3 5 7 5
 c. Find the critical path.
Construct a network diagram:
calculate the time earliest, TE and time Latest TL for all the activities
From the network diagram Figure, the critical path is identified as 1-2, 2-4, 4-
5, 5-6 with a project duration of 28 days.
From the table, the critical
nodes are (1-2), (2-4), (4-
5), and (5-6)

Therefore, the possible

critical path is
1→2→4→5→6
d. Calculate variance and standard deviation for critical path.
Activity To Tm TP TE ES EF LS LF Variance

1-2 4 6 8 6 0 6 0 6 0.444
2-3 2 3 10 4 6 10 12 16 1.778
2-4 6 8 16 9 6 15 6 15 2.778
2-5 1 2 3 2 6 8 21 23 0.111
3-5 6 7 8 7 10 17 16 23 0.111
4-5 6 7 14 8 15 23 15 23 1.778
5-6 3 5 7 5 23 28 23 28 0.444

Standard deviation for critical path

𝛿= 0.44 + 2.78 + 1.78 + 0.44 = 2.33

e. Find the probability of completing the project at 32 days

𝑋−𝜇
𝑍=
𝛿

Where X = expected days = 32

𝜇 = TE = 28
𝛿 = 2.33
32−28 4
𝑍= = = 1.72
2.33 2.33

Probability of completing project is 95.73%

 Comparison Between CPM and PERT

Sl.n CPM PERT

Uses network, calculate float or
1 slack, identify critical path and Same as CPM
activities, guides to monitor and
controlling project
Uses one value of activity time Requires 3 estimates of activity time
2 Calculates mean and variance of time
Used where times can be estimated Used where times cannot be estimated
3 with confidence, familiar activities with confidence. Unfamiliar or new
activities
Minimizing cost is more important Meeting time target or estimating
4 percent completion is more important
Example: construction projects, Example: Involving new activities or
5 building one off machines, ships, etc products, research and development
etc
 Gantt Chart
• A GANTT chart is a type of bar chart that illustrates a project schedule.

• After the PERT/CPM analysis is completed, the following phase is to

construct the GANTT chart and then to re-allocate resources and re-
schedule if necessary.

• GANTT charts have become a common technique for representing the

phases and activities of a project work breakdown structure.

• It was introduced by Henry Gantt around 1910 – 1915.

Constructing Gantt Chart

❑ The steps to construct a GANTT chart from the information

obtained by PERT/CPM are:
1. Schedule the critical tasks in the correct position.
2. Place the time windows in which the non-critical tasks
can be scheduled.
3. Schedule the non-critical tasks according to their
earliest starting times.
4. Indicate precedence relationships between tasks.
Constructing Gantt Chart

❑Example of an early GANTT chart construction:

 Constructing Gantt Chart
Step 1. Schedule critical tasks:
 Constructing Gantt Chart
Step 2. Place time windows for non-critical tasks:
Constructing Gantt Chart
Step 3. Schedule non-critical tasks
Step 4. Indicate precedence relationships:
PROJECT CRASHING
 COST ANALYSIS
• The two important components of any activity are the cost and time. Cost is
directly proportional to time and vice versa.
Normal time:
• Normal time is the time required to complete the
activity at normal conditions and cost.
Crash time:
• Crash time is the shortest possible activity time;
crashing more than the normal time will increase
the direct cost.
Cost Slope
• Cost slope is the increase in cost per unit of time
saved by crashing. A linear cost curve is shown in
Figure .
 Crashing
Crashing: The network diagram can be used to identify the activities whose
duration should be shortened so that the completion time of the project
can be shortened in the most economic manner. The process of reducing
the activity duration by putting on extra effort is crashing.

Cost slop: The cost slop indicating the increased in cost per unit reduction in
time defined as cost slope
 Four Steps to Project Crashing
1. Find the normal critical path and identify the critical activities

2. Compute the crash cost per week (or other time period) for all
activities in the network using the formula
Crash cost – Normal cost
Crash cost/Time period =
Normal time – Crash time

3. Select the activity on the critical path with the smallest crash cost
per period and crash this activity to the maximum extent possible or
to the point at which your desired deadline has been reached
4. Check that the critical path you were crashing is still critical. If the
critical path is still the longest path through the network, return to
step 3. If not, find the new critical path and return to step 3 .
 Computing crash data
❑Given:
✓ activities
✓ normal time
✓ normal cost
✓ crash time
✓ crash cost
❑Compute:
✓ maximum time reduction
✓ cost to crash per period
 Crashing
• Obtaining reduction in time at an increased cost (increasing the employed
resources).
• Cost-slope: the cost of reducing duration time by unit time.
• Let’s see the following example:
Normal Crash 1. Draw project
Activity Normal cost Crash cost network
time time
1-2 3 2 5000 7000 2. Compute PERT
2-3 4 2 6000 10000
3. Find critical path
2-4 3 1 9000 17000
2-5 4 3 5000 9000 4. Assume overhead
3-5 2 1 5000 9500 cost is 6000 Birr,
what is optimal
4-5 5 2 7000 16000
solution for
5-6 5 5 20000 20000
project.
1. Draw project network
2. Compute PERT
3.Find critical path
4. Assume overhead cost is 6000 Birr, what is optimal solution for project.
Before go to crash the project we must be calculate the following data

Activity TN TC CN CC Time Cost Slope

1-2 3 2 5000 7000 1 2000 2000

2-3 4 2 6000 10000 2 4000 2000
2-4 3 1 9000 17000 2 8000 4000
2-5 4 3 5000 9000 1 4000 4000
3-5 2 1 8000 9500 1 1500 1500
4-5 5 2 7000 16000 3 9000 3000
5-6 5 5 20000 20000 0 0 0
Total cost 60,000 88,500
 Cont…..

Before go to crash the project we must be calculate the following data

Direct cost = σ 𝑛𝑜𝑟𝑚𝑎𝑙 𝑡𝑖𝑚𝑒

Indirect cost = 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑑𝑎𝑡𝑒 ∗ 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡 = 16 ∗ 6000

Total cost = σ 𝑑𝑖𝑟𝑒𝑐𝑡 𝑐𝑜𝑠𝑡 + 𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑐𝑜𝑠𝑡

= σ 𝑛𝑜𝑟𝑚𝑎𝑙 𝑡𝑖𝑚𝑒 + 𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑐𝑜𝑠𝑡 ሺ𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑜𝑚𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑑𝑎𝑡𝑒 ∗

𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡ሻ

𝑇𝐶 = 60.000 + 16 ∗ 6000 = 𝟏𝟓𝟔, 𝟎𝟎𝟎 𝐵𝑖𝑟𝑟

 Cont…..
All possible path Normal days Crashed days
1-2-4-5-6 16 10
1-2-3-5-6 14 10
1-2-5-6 12 10

Using the path 1-2-4-5-6 or 1-2, 2-4, 4-5, 5-6

A. Therefore, 1-2 has the lowest cost, then crash activity 1-2 by 1 day. Project
duration is 15 days
Cost = 156,000+1*2000-6000

= 152,000 Birr

Note activity 1-2 cannot be crashed further.

 Cont…..

B. Again path 1-2,2-4,4-5,5-6 is critical path

Since activity 4-5 has lowest cost crash it by 1 day. PD is 14 days.
Cost = 152,000+3000-6000
= 149,000 Birr
C. Again crash activity 4-5 by 1 day. PD is 13 days
Cost = 149,000+3000-6000 = 146,000 Birr
Cont…..
 Cont…..

As the cost increased, there is no need to crash the project further

Therefore, the optimum cost of project is 144,500 Birr at 11 days of crashed project
duration and the maximum crashed time is 5 days
Resource Scheduling
 What is resource scheduling?
Refers to efficiently allocate organizations resources to tasks

Using time-constrained and resource-constrained it incorporates

decisions about capacity into the scheduling process
1. Time-constrained scheduling uses the time factor as its critical
variable.

2. Resource-constrained focuses on the limited capacity of resources,

emphasizing resolving capacity overload problems.

2/24/2024 65
 Resource scheduling importance
✓Improve efficiency and cost of the project

✓Prevent timeline delays

✓Prevent work overloading

✓Assign tasks and monitor projects from start to finish

✓Schedule labor based on skills and availability

✓Analyze the utilization rate for each of the resources and reassign tasks to
resources that are not working to their full utilization rates

✓Track project estimations and outcomes to make future scheduling easier

 What are the steps for effective resource scheduling?
Here are six steps in effective resource scheduling.
1. Break down tasks
2. Evaluate resource capabilities
3. Execute risk plan for critical resources

4. Identify bottlenecks and adjust quickly in real-time

5. Assign tasks to employees based on their availability

6. Track the time spent on tasks and activities

2/24/2024 67
 Project scheduling with limited resources
Usually the resources in project are:
❑Manpower
❑Equipment's
❑Money
Hence the objective is to adjust noncritical activities between their EST &
LFT such that the peak resource requirement is reduced.
There are 2 types of problems under this category.
1. Resource leveling (to minimize the peak requirement and smooth out
period to period variation).
2. Resource allocation (adjust the noncritical activities such that the
resource requirement in each period is within the available range).
2/24/2024 68
 Resource Leveling Technique
Ex: Consider the following problem of project scheduling to obtain a schedule
which will minimize the peak manpower requirement and smooth out period to
period variation of manpower requirement.
Activity Duration Manpower requirement
1-2 6 8
1-3 10 4
1-4 6 9
2-3 10 7
2-4 4 6
3-5 6 17
4-5 6 6
2/24/2024 69
 The EST & LFT for each event are presented in boxes.
Activities representation on a time state and corresponding manpower requirements are
presented on the top of arrow as follows

The peak manpower

requirement is 21 and it
occurs between 0-6 Activity
weeks. 3-5=17

Let postpone activity 1-3 at the end of 6th week

Activity
3-5=17

The manpower requirement is now

balanced/smothered throughout the project duration.
 Resource Allocation Technique

➢The objective of resource allocation is to reschedule the

manpower requirement in each period of project execution is

within the maximum manpower limit which is given as a

constraints.

➢Here we should aim to maintain a limit on the manpower

requirement throughout the project duration.

2/24/2024 72
 Ex. Consider the following problem

Activity Duration in month Manpower requirement

1-2 4 10
1-3 5 4
2-3 8 5
2-4 8 2
3-4 4 7
Reschedule the activities of the project with a maximum limit on the
manpower requirement = 10
2/24/2024 73
Now the manpower
requirement with month
is presented in the next
slide table.
Solution:
The project network and the various time values are shown below.

The critical path = 1-2-3-4

The normal project completion time = 16 months

2/24/2024 75
 The normal project scheduling with manpower requirement (on the
top of arrow) is shown below.

2/24/2024 76
✓ If the actual manpower allocated as per the project schedule is
more than the upper limit of 1, then the non-critical activities are
postponed with the most slack value so that the actual manpower
on that month is less than or equal to the maximum limit.
✓ In spite of this if the total manpower goes beyond the maximum
limit, then the critical activity is to be postponed by some period
such that total manpower is within the maximum limit. It is shown
in the following
2/24/2024 77
Now the manpower requirement with month is presented in the next slide
table.
2/24/2024 78
Month 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

Manpower
10 10 10 10 9 9 9 9 9 7 7 7 2 9 9 9 9
requirement

It is seen that the project duration is changed from 16 months to

17 months due to limitation of resource.

2/24/2024 79
 CHAPTER SIX
Investment Evaluation
✓Engineering Economics

✓Investment Evaluation and Budgetary control

✓Comparison and Selection Among Alternatives

 Engineering Economy
• It deals with the concepts and techniques of analysis useful in evaluating
the worth of systems, products, and services in relation to their costs

• It is used to answer many different questions

• Which engineering projects are worthwhile?
• Has the mining or petroleum engineer shown that the mineral or oil deposits is worth developing?

• Which engineering projects should have a higher priority?

• Has the industrial engineer shown which factory improvement projects should be funded with the
available dollars?

• How should the engineering project be designed?

• Has civil or mechanical engineer chosen the best thickness for insulation? 81
 The Principles of Engineering Economy

• Develop the Alternatives- Carefully define the problem! Then the

choice (decision) is among alternatives. The alternatives need to be

identified and then defined for subsequent analysis.

• Focus on the Differences-Only the differences in expected future

outcomes among the alternatives are relevant to their comparison and

should be considered in the decision.

 The Principles of Engineering Economy…
• Use a Consistent Viewpoint-The prospective outcomes of the

alternatives, economic and other, should be consistently developed

from a defined viewpoint (perspective).

• Use a Common Unit of Measure-Using a common unit of

measurement to enumerate as many of the prospective outcomes as

possible will simplify the analysis of the alternatives.

 The Principles of Engineering Economy…

• Consider All Relevant Criteria-Selection of a preferred alternative

(decision making) requires the use of a criterion (or several criteria).

The decision process should consider both the outcomes enumerated

in the monetary unit and those expressed in some other unit of

measurement or made explicit in a descriptive manner.

 The Principles of Engineering Economy…

• Make Risk and Uncertainty Explicit-Risk and uncertainty are inherent in

estimating the future outcomes of the alternatives and should be recognized
in their analysis and comparison.

• Revisit Your Decisions

• Improved decision making results from an adaptive process; to the extent

practicable, the initial projected outcomes of the selected alternative should
be subsequently compared with actual results achieved.
 Engineering Economic Analysis Procedure

Step
1.Problem recognition, definition, and Evaluation
2.Development of the feasible alternatives.
3.Development of the outcomes and cash flows
for each alternative.
4.Selection of a criterion (or criteria).
5.Analysis and comparison of the alternatives.
6.Selection of the preferred alternative.
7.Performance monitoring and post-evaluation of
results.
Activity
1. Problem/need definition.
2. Problem/need formulation and
evaluation.
3. Synthesis of possible solutions
(alternatives).
4. Analysis, optimization, and evaluation
5. Specification of preferred alternative.
6. Communication.
 Time Value of Money

Since a person who has money has certain advantages over a person who
doesn’t, people are willing to pay for that advantage

(As a function of time)

Clearly then, money has time value
Equivalence
Time value of money leads to equivalence:
Different sums of money at different times can be considered to be equal to
each other

(At a certain interest rate)

 Equivalence Calculations
Let P = present sum
F = future sum
i = interest rate
n = no. of interest periods
For P=$1,000 i=20%/yr. n=1 yr.
F= 1,000 + 1,000(0.20) =$1,200
Thus, $1,000 now = $1,200 1 yr.
from now
Simple & Comp'd Interest
Simple interest: interest rate applies to
% principal only
Comp’d interest: interest rate
applies to
principal and accrued interest
 Single Payment Compound Interest

Beginning
Year Interest for period Ending balance
balance
1 P iP P(1+i)
2 P(1+i) iP(1+i) P(1+i)2
3 P(1+i)2 iP(1+i)2 P(1+i)3
n P(1+i)n-1 iP(1+i)n-1 P(1+i)n

P at time 0 increases to P(1+i)n at the end of time n.

Or a Future sum = present sum (1+i)n

 Notation for calculating a future value

• Formula: F=P(1+i)n

is the single payment compound amount factor.

• Functional notation:

F=P(F/P,i,n)

F=5000(F/P,6%,10)

• F =P(F/P) which is dimensionally correct.

 Simple & Comp'd Interest…

Example: Determine the amount available in 3 years if $

10,000 is deposited now at 20% per year
a. simple and,
b. Compound interest t
Solution:
a. Simple interest
F = principal + interest
= P + P(n)(i)
= 10,000 +10,000(3)(0.20)
= $16,000
Simple & Comp'd Interest…
Example: Determine the amount available in 3 years if $ 10,000
is deposited now at 20% per year,
a. simple and,
b. Compound interest
Solution: b. Comp’d interest

F1 = 10,000+10,000(0.20) = 12,000
F2= 12,000+12,000(0.20) = 14,400
F3= 14,400+14,400(0.20) = $17,280
Investment Evaluation
and
Budgetary control
 The Finance Function

Financial
Operations
Manager
(Plant, (1a) Raise Financial
Equipment, (2) Investment Funds
Markets
Projects, (Investors)
etc.) (1b) Obligations
(Stocks, Debt, IOUs)

(4) Reinvest

(3) Cash from (5) Dividends or

Operations Interest Payments

The finance function manages the cash flow

 Cont…

Finance focuses on these two decisions

Investment Financing Financial

Operations
Decision Financial Decision Markets
Manager

How much to Where is the $

invest and in going to come
what assets? from?
Capital Budgeting
Interaction between Financing & Investment Decisions
The interplay of the decisions determines the cost of capital

Characteristics
of the
Investment

Investment Financial Financing Financial

Operations Decision
Manager Decision Markets

Cost of Capital
 The Finance Function
By making investing and financing decisions, the financial
manager is attempting to achieve the following objective:

• The objective of the financial manager and the corporation is to

Maximize the current value of shareholders' wealth.

• (Taken literally, this means that a firm should pursue policies that

maximize its today's quotation in the Wall Street Journal.)

 Investment Evaluation in 3 Basic Steps
1. Forecast all relevant after tax expected cash flows generated by the
project
2. Estimate the opportunity cost of capital-r (reflects the time value of money
and the risk)
3. Evaluation IRR (internal rate of return
DCF (discounted cash flows) Accept project if IRR > r
NPV (net present value) Payback, Profitability Index
Accept project if NPV is positive ROA, ROFE, ROI, ROCE
Reject project if NPV is negative ROE
EVA
 REVENUE-DOMINATED CASH FLOW DIAGRAM

• A generalized revenue-dominated cash flow diagram to demonstrate the

present worth method of comparison is presented salvage value
at the end of
the nth year

Rj the net revenue at the end of

P Is initial investment the jth year

1 1 1 1 1
𝑃𝑊ሺ𝑖ሻ = – 𝑃 + 𝑅1[ ] + 𝑅2[ ] + … + 𝑅𝑗[ ] + 𝑅𝑛[ ] + 𝑆[ ]
1+𝑖 1 1+𝑖 2 1+𝑖 𝑗 1+𝑖 𝑛 1+𝑖 𝑛
 COST-DOMINATED CASH FLOW DIAGRAM
• A generalized cost-dominated cash flow diagram to demonstrate the
present worth method of comparison is presented
salvage value
Cj the net cost of operation and maintenance at the end of
at the end of the jth year the nth year

P Is initial investment

1 1 1 1 1
𝑃𝑊ሺ𝑖ሻ = – 𝑃 + 𝐶1[ ] + 𝐶2[ ] + … + 𝐶𝐽[ ] + 𝐶𝑛[ ] + 𝑆[ ]
1+𝑖 1 1+𝑖 2 1+𝑖 𝑗 1+𝑖 𝑛 1+𝑖 𝑛
 Series present worth factor
The present value of P if an amount A is invested at the end of
each year,
1+𝑖 𝑛 −1
𝑃 =𝐴
𝑖 1+𝑖 𝑛
Capital recovery factor
The amount A that should be invested at the end of each year, if
amount P is invested at the beginning of first year,
𝑖 1+𝑖 𝑛
𝐴 = 𝑃
[ 1 + 𝑖 𝑛 − 1]
EXAMPLE: - Alpha Industry is planning to expand its production operation.
It has identified three different technologies for meeting the goal. The initial
outlay and annual revenues with respect to each of the technologies are
summarized. Suggest the best technology which is to be implemented based
on the present worth method of comparison assuming 20% interest rate,
compounded annually.
Solution: - Technology 1
Initial outlay, P = Rs. 12,00,000
Annual revenue, A = Rs. 4,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
PW(20%)=-1200000+400000(((1+0.2)^10-
1)/〖0.2(1+i)〗^10 )=-
1,200,000+400,000(4.192)=-
1200,000+1,676,800=476,800
Solution: - Technology 2
Initial outlay, P = Rs. 20,000,000
Annual revenue, A = Rs. 6,000,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
PW(20%)=-
20,000,000+6,000,0000(((1+0.2)^10-1)/〖
0.2(1+i)〗^10 )=-
20,000,000+6,000,0000(4.192)=-
20,000,000+ 25,152,000 = 5,152,000
Solution: - Technology 3 Compare

Initial outlay, P = Rs. 18,000,000 The solution of three technology results,

Annual revenue, A = Rs. 5,000,000 decided which projects are acceptable.

Interest rate, i = 20%, compounded annually 1. Technology 1= 476,800

Life of this technology, n = 10 years 2. Technology 2= 5,152,000

PW(20%)=- 3. Technology 3= 2,960,000

18,000,000+5,000,0000(((1+0.2)^10-1)/〖 The project with greater value is acceptable.

0.2(1+i)〗^10 )=-
Therefore, Technology 2= 5,152,000 is
18,000,000+5,000,0000(4.192)=-
acceptable project.
18,000,000+ 20,960,000 = 2,960,000
Forecasting Cash Flows: The Ten Commandments
1) Depreciation is not a cash flow, but it affects taxation
Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.

= Operating Profit
- Cash Taxes on Operating Profit

= Net Operating Profit After Tax

+ Depreciation
- Capital Expenditures
- Increase in Working Capital

= Cash Flow from Operations

 Cont…
2) Do not ignore investment in fixed assets.

Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.

= Operating Profit
- Cash Taxes on Operating Profit

= Net Operating Profit After Tax

+ Depreciation
- Capital Expenditures
- Increase in Working Capital

= Cash Flow from Operations

 Cont…
3) Do not ignore investment in net working capital.

Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.

= Operating Profit
- Cash Taxes on Operating Profit

= Net Operating Profit After Tax

+ Depreciation
- Capital Expenditures
- Increase in Working Capital

= Cash Flow from Operations

 Cont…

• There is an important distinction between the accounting definition of

working capital and the economic/finance definition relevant to cash

flows forecast.

• The distinction is a direct result of the 4𝑡ℎ commandment above: We

need the operating working capital, not the operating and financial

working capital.
 Cont…
Accounting Definition of Working Capital
Working Capital = Current Assets - Current Liabilities

Accounts receivable Accounts payable

Inventory Accrued taxes
Cash (required for operations) Accrued wages
Excess Cash & marketable short-term debt
securities

• Current assets include operating assets (above dotted line). However, excess cash and marketable
securities not required for operations (below dotted line) are not operating working capital and
accounted separately for value (see 10th commandment).
• Current liabilities include both operating liabilities (above the dotted line) and non-operating short-
term debt (below the dotted line).
 Cont…
4) Separate investment and financing decisions
Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.

= Operating Profit
Evaluate as if
- Cash Taxes on Operating Profit
entirely equity
financed
= Net Operating Profit After Tax
Ignore
+ Depreciation
financing/
- Capital Expenditures
no interest line
- Increase in Working Capital
item
= Cash Flow from Operations
 Cont…
5) Estimate flows on an incremental basis
Incremental = total firm cash flow - total firm cash flow
Cash Flow WITH the project WITHOUT the project

•Forget Sunk Costs –

costs incurred in the past and irreversible

•Include all effects of the project on the rest of the firm (e.g., cannibalization,
erosion, enhancement, etc.)
 Cont…

6) Opportunity costs cannot be ignored

What other
uses could
resources be
put to?

The cost of any resource is the foregone opportunity of

employing this resources in the next best alternative use.
 Cont…

7) Do not forget continuing value (residual or terminal)

Two approaches are available:
• Liquidation value: Estimate the proceeds from the sale of assets after
the explicit forecast period. (Include the recovery of investment in
working capital, tax-shield on the undepreciated fixed assets and any
revenue from assets sale).
• This approach results in under-valuation since it misses the value of
on-going business. It ignores the value of intangibles.
 Cont…
• Perpetual growth: Assumes that after time n cash flows are expected to
grow at a constant rate perpetually.

Terminal Value

... Year n+1 & on

Year 1 Year 2 Year n
CFn+1/(r-g)
CF1 CF2 CFn
 Cont…
8) Be consistent in the
treatment of inflation Nominal vs.
Real Cash Flows
Discount nominal cash flows with nominal cost of capital
Discount real cash flows with real cost of capital 1 2 3
Common Mistake: Nominal (inflation adjusted) Nominal 2.00 2.08 2.16
Real 2.00 2.00 2.00
discount rate used to discount real cash flows
Bias towards short-term investment
Inflation @ 4%

Note: Depreciation is based on

4% Inflation
7%
Nominal
{
3% Real
historical costs and therefore is
not adjusted for inflation
Nominal Rate  Real Rate + Inflation
 Cont…

9) Overhead costs
Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.
Do not forget
= Operating Profit
overheads and - Cash Taxes on Operating Profit
other indirect
costs that = Net Operating Profit After Tax
increase due + Depreciation
- Capital Expenditures
to the project
- Increase in Working Capital

= Cash Flow from Operations

 Cont…
10) Include excess cash, excess real estate, unfunded (over-funded)
pension funds, large stock option obligations
Year 1 Year 2 Year 3 Year 4 Year 5 . . . Terminal
CF1 CF2 CF3 CF4 CF5 CFn+1/(r-g)

PV(Operating Cash Flows)

+ Excess cash balance
+ Excess marketable securities Assets/Liabilities not
+ Excess real estate required to support
operations
- Under-funded pension
=Value of the FIRM
 Value of Equity

Value of the Firm

-Value of Debt
=Value of Equity

To calculate share price-divide by the number of shares outstanding

 3. Evaluation

There are several bases for comparing the worthiness of the projects.
These bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
 Present worth method
✓The cash flows of each alternative will be reduced to time zero by assuming an
interest rate i.

✓Then, depending on the type of decision, the best alternative will be selected by
comparing the present worth amounts of the alternatives.

➢The selection guidelines for PW analysis are;

✓FW≥0 means the MARR is met or exceeded.

✓If PW(i) = 0, remain indifferent.

✓ For two or more mutually exclusive alternatives select the one with the
numerically largest PW value.
 Future Worth Analysis

➢The selection guidelines for FW analysis are the same as for

PW analysis;

• FW≥0 means the MARR is met or exceeded.

➢ For two or more mutually exclusive alternatives,

• Select the one with the numerically largest FW value.

 Annual Worth Analysis
One alternative:
• If AW≥0, the requested MARR is met or exceeded and the
alternative is economically justified.

Two or more alternatives:

• Select the alternative with the AW that is numerically largest, that
is, less negative or more positive.
• This indicates a lower AW of cost for cost alternatives or a larger
AW of net cash flows for revenue alternatives.
 Rate of Return Analysis:
• Rate of return (ROR) is the rate paid on the unpaid balance of borrowed
money, or the rate earned on the unrecovered balance of an investment,
so that the final payment or receipt brings the balance to exactly zero with
interest considered.

• The rate of return is the interest rate that makes the present worth or annual
worth of a cash flow series exactly equal to 0.
✓If i ≥MARR, accept the project as economically viable.
✓If i <MARR, the project is not economically viable.
 Benefit/Cost Analysis

The decision guideline is simple:

✓If B/C≥1.0, accept the project as economically justified for the

estimates and discount rate applied.

✓If B/C<1.0, the project is not economically acceptable.

 Evaluation Methods: NPV
Net Present worth Criterion
✓Determine the interest rate that the firm wishes to earn on its investment
✓Estimate the service life of the project.
✓Estimate the cash flow over each service period
✓Determine the net cash flows, i.e.
❑Net cash flow=Cash Inflow-Cash Outflow
The decision rule is:
1. If P(i) > 0, accept the investment
2. If P(i) = 0, remain indifference
3. If P(i) < 0 reject the investment
 Net Present Value
• Present Value of all costs and benefits (measured in terms of incremental
cash flows) of a project.

• Concept is similar to Discounted Cashflow model for valuing securities

but subtracts of cost of project.

NPV = PV of Inflows - Initial Investment

CF1 CF2 CFn

NPV = (1+ r)1 + (1+ r)2
+…. (1+ r )n
– Initial Investment
13
 Cont..
What is the NPV for Project B?
P R O J E C T
Solution
Time A B
0 (10,000) (10,000) r=10%
1 3,500 500
2 3,500 500
3 3,500 4,600 (10,000) 500 500 4,600 10,000
4 3,500 10,000

500 500
𝑁𝑃𝑉 = + + = 454.55 + 413.2 + NPV > $0
1+0.1 1 1+0.1 2
3456 + 6830-10,000 $1,154 > $0
4600 10000
+ -10,000 14
1+0.1 3 1+.1 4 =11154-10,000 =1153.89
 NPV Decision Rule

Accept the project if the NPV is greater than or equal to 0.

Example:

• NPVA = $1,095 > 0 accept

• NPVB = $1,154 > 0 accept

• If projects are independent, accept both projects.

• If projects are mutually exclusive, accept the project with the

36
higher NPV.
 Calculation of IRR
The IRR is the r that solves
500 500 4600 10000
0= + + + -
1+𝑟 1 1+𝑟 2 1+𝑟 3 1+𝑟 4
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑛
0= + + +….. -CF0
1+ 𝑟 1 1+𝑟 2 1+ 𝑟 3 1+ 𝑟 𝑛 .
10,000

Decision Rule: Accept the project if With 10% the value is 1153.89
Therefore, the value must be
IRR > Opportunity Cost of Capital above 10%
Let try with 15%
From previous projects
Time A B
500 500 4600 10000
0 (10,000) (10,000) 0= + + + -10,000
1.15 1 1.15 2 1.15 3 1.15 4
1 3,500 500
2 3,500 500
3 3,500 4,600 0 = 434.78+378+3,024.57+5,717.53-10,000
4 3,500 10,000
= -445.12
 Calculation of IRR
Let try with 14% Let try with 13.5%
500 500 4600 10000
500 500 4600 0= + + + -10,000
0= + + + 1.135 1 1.135 2 1.135 3 1.135 4
1.14 1 1.14 2 1.14 3
10000
-10,000 0 = 440+388+3146+6025-10,000= 0
1.14 4
0 = 439+385+3105+5921-10,000= -150
Let try with 13% Since NPV = 0
0=
500
+
500
+
4600
+
10000
-10,000 IRRB = 13.50%
1.13 1 1.13 2 1.13 3 1.13 4
Calculate project A by yourself
0 = 442+396+3188+6133-10,000= 159
IRRA = 14.96%
Therefore, it lays between 14% and 13%
 Other Evaluation Methods
Profitability Index: PV/I. Problem: Biases against large-scale projects.

Payback: How long does it take for the project to payback?

Time Period: 0 1 2 3 4 5 Problems:
Project A -100 20 30 50 Pass • No discounting the first 3 years
Project B -10 2 2 2 10 5B Fail • Infinite discounting of later years
Corporate Rule: Project must payback in at most 3 years! Biases against long-term projects.

}
ROA (return on assets)
ROI (return on investment) Earnings
= Investment
ROFE (return on funds employed)
ROCE (return on capital employed) Problems:
•Investment not valued at market
Net Income
ROE = •Earnings vs. cash flows
Shareholders’ Equity
Book Value
 Comparison and Selection Among Alternatives
• Most engineering projects can be accomplished by more than one feasible design alternative.
• When the selection of one of these alternatives excludes the choice of any of the others, the
alternatives are called mutually exclusive.
• Typically, the alternatives being considered require the investment of different amounts of capital,
and their annual revenues and costs may vary.
• Sometimes the alternatives may have different useful lives.
• The fundamental question is “do the added benefits from a more-expensive alternative bring a
positive return relative to the added costs?”
• A basic methods for economic comparison of alternatives for an engineering project is present
worth (PW), annual worth (AW), future worth (FW), internal rate of return (IRR), and external
rate of return (ERR)].
• These provide When correctly applied, these methods result in the correct selection of a preferred
alternative from a set of mutually exclusive alternatives.
 Comparison and Selection Among Alternatives

➢ The objective is to evaluate correctly capital investment

alternatives when the time value of money is a key influence.

✓ Making decisions means comparing alternatives.

✓ The decisions considered are those selecting from among a set of

mutually exclusive alternatives—when selecting one excludes the

choice of any of the others.

 Mutually Exclusive Alternatives (Meas)
• We examine these on the basis of economic considerations alone.

• The alternatives may have different initial investments and their annual
revenues and costs may vary.

• The alternatives must provide comparable “usefulness”: performance,

quality, etc.

• The basic methods from chapter 6 provide the basis for economic
comparison of the alternatives.
 Apply this rule, based on Principle 2

• The alternative that requires the minimum investment of capital

and produces satisfactory functional results will be chosen unless
the incremental capital associated with an alternative having a
larger investment can be justified with respect to its incremental
benefits.

• This alternative is the base alternative.

 For alternatives that have a larger investment than the base…

• If the extra benefits obtained by investing additional capital are better than

those that could be obtained from investment of the same capital elsewhere

in the company at the MARR, the investment should be made. (Please note

that there are some cautions when considering more than two alternatives,

which will be examined later.)

 For alternatives that have a larger investment than the base…
❑There are two basic types of alternatives.
• Investment Alternatives
• Those with initial (or front-end) capital investment that produces positive cash
flows from increased revenue, savings through reduced costs, or both.
• Cost Alternatives
• Those with all negative cash flows, except for a possible positive cash flow from
disposal of assets at the end of the project’s useful life.
• Select the alternative that gives you the most money!
• For investment alternatives the PW of all cash flows must be positive, at the MARR,
to be attractive. Select the alternative with the largest PW.
• For cost alternatives the PW of all cash flows will be negative. Select the alternative
with the largest (smallest in absolute value) PW.
 Investment alternative example
Use a MARR of 10% and useful life of 5 years to select between the investment
alternatives below.
Alternative
A B
Capital investment -$100,000 -$125,000
Annual revenues less expenses $34,000 $41,000

• Both alternatives are attractive, but Alternative B provides a greater present worth,
so is better economically.
 Cost alternative example
Use a MARR of 12% and useful life of 4 years to select between the cost alternatives below.

Alternative
C D
Capital investment -$80,000 -$60,000
Annual expenses -$25,000 -$30,000

Alternative D costs less than Alternative C, it has a greater PW, so is better economically.
 Pause and Solve
Your local foundry is adding a new furnace.
There are several different styles and types of furnaces, so the foundry must select from
among a set of mutually exclusive alternatives.
Initial capital investment and annual expenses for each alternative are given in the table
below.
None have any market value at the end of its useful life. Using a MARR of 15%, which
furnace should be chosen?
Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
 Solution
Using a MARR of 15%, the PW is shown for each of the three alternatives in the table below.

Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
Present Worth @ 15% -$380,010 -$384,094 -$364,010

The largest value is -$364,010, indicating that Furnace F3 is the best alternative.
 Determining the study period.
• A study period (or planning horizon) is the time period over which
MEAs are compared, and it must be appropriate for the decision
situation.

• MEAs can have equal lives (in which case the study period used is
these equal lives), or they can have unequal lives, and at least one
does not match the study period.

• The equal life case is straightforward, and was used in the previous
two examples.
 Unequal lives are handled in one of two ways.
• Repeatability assumption
• The study period is either indefinitely long or equal to a common multiple of the
lives of the MEAs.

• The economic consequences expected during the MEAs’ life spans will also
happen in succeeding life spans (replacements).

• Co-terminated assumption: uses a finite and identical study period for

all MEAs. Cash flow adjustments may be made to satisfy alternative
performance needs over the study period.
 Comparing MEAs with equal lives.
When lives are equal adjustments to cash flows are not required. The MEAs can be
compared by directly comparing their equivalent worth (PW, FW, or AW) calculated
using the MARR. The decision will be the same regardless of the equivalent worth
method you use. For a MARR of 12%, select from among the MEAs below.
Alternatives
A B C D
Capital investment -$150,000 -$85,000 -$75,000 -$120,000
Annual revenues $28,000 $16,000 $15,000 $22,000
Annual expenses -$1,000 -$550 -$500 -$700
Market Value (EOL) $20,000 $10,000 $6,000 $11,000
Life (years) 10 10 10 10
 Selecting the best alternative.
Present worth analysis → select Alternative A (but C is close).

Annual worth analysis—the decision is the same.

Using rates of return is another way to compare alternatives.
• The return on investment (rate of return) is a popular measure of investment
performance.

• Selecting the alternative with the largest rate of return can lead to incorrect decisions—
do not compare the IRR of one alternative to the IRR of another alternative. The only
legitimate comparison is the IRR to the MARR.

• Remember, the base alternative must be attractive (rate of return greater than the
MARR), and the additional investment in other alternatives must itself make a
satisfactory rate of return on that increment.
 Use the incremental investment analysis procedure.
• Arrange (rank order) the feasible alternatives based on increasing capital
investment.

• Establish a base alternative.

• Cost alternatives—the first alternative is the base.
• Investment alternatives—the first acceptable alternative (IRR>MARR)
is the base.

• Iteratively evaluate differences (incremental cash flows) between

alternatives until all have been considered.
 Evaluating incremental cash flows
• Work up the order of ranked alternatives smallest to largest.

• Subtract cash flows of the lower ranked alternative from the higher ranked.

• Determine if the incremental initial investment in the higher ranked alternative is

attractive (e.g., IRR>MARR, PW, FW, AW all >0). If it is attractive, it is the
“winner.” If not, the lower ranked alternative is the “winner.” The “loser” from this
comparison is removed from consideration. Continue until all alternatives have been
considered.

• This works for both cost and investment alternatives.

 Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,200 $3,200
IRR on total cash flow 15% 14% 11%

• Which is preferred using a 5 year study period and MARR=10%?

• Both alternatives A and B are acceptable—each one has a rate of return that exceeds the
MARR. Choosing Alternative A because of its larger IRR would be an incorrect
decision. By examining the incremental cash flows we see that the extra amount invested
in Alternative B earns a return that exceeds the IRR—so B is preferred to A. Also note…
 Pause and solve
Acme Molding is examining 5 alternatives for a piece of material handling equipment.
Each has an expected life of 8 years with no salvage value, and Acme’s MARR is 12%.
Using an incremental analysis, which material handling alternative should be chosen?
The table below includes initial investment, net annual income, and IRR for each
alternative.
Alternative
A B C D E
Capital $12,000 $12,500 $14,400 $16,250 $20,000
investment
Net annual $2,500 $2,520 $3,050 $3,620 $4,400
income
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
 Solution
Alternative A is the base alternative, with an IRR > MARR. The next largest investment
is in Alternative B, so first examine the incremental investment of B over A. In the table
below the IRR of B – A is shown.

Alternative
A B B-A
Capital $12,000 $12,500 $500
investment
Net annual $2,500 $2,520 $20
income
IRR 12.99% 12.04% -20.11%

Alternative B is not better than A—A “wins.”

 Solution
The next largest investment is in Alternative C, so examine the incremental investment of C over A. In the
table below the IRR of C – A is shown.
Alternative
A C C-A
Capital investment $12,000 $14,400 $2,400
Net annual income $2,500 $3,050 $550
IRR 12.99% 13.48% 15.86%

15.86% > MARR, so Alternative C “wins.”

The next largest investment is in Alternative D, so examine the incremental investment of D
over C. In the table below the IRR of D – C is shown.
Alternative
C D D-C
Capital investment $14,400 $16,250 $1,850
Net annual income $3,050 $3,620 $570
IRR 13.48% 14.99% 25.94%

25.94% > MARR, so Alternative D “wins.”

 Solution
Finally, examine the incremental investment of E over D.
Alternative
D E E-D
Capital investment $16,250 $20,000 $3,750

Net annual income $3,620 $4,400 $780

IRR 14.99% 14.61% 12.95%

12.95% > MARR, so Alternative E “wins,” and we would select Alternative E as

the best of these five alternatives.
 Comparing MEAs with unequal lives.
• The repeatability assumption, when applicable, simplified
comparison of alternatives.

• If repeatability cannot be used, an appropriate study period

must be selected (the co-terminated assumption).

• This is most often used in engineering practice because

product life cycles are becoming shorter.
 The useful life of an alternative is less than the study period.
• Cost alternatives
• Contracting or leasing for remaining years may be appropriate
• Repeat part of the useful life and use an estimated market value to
truncate

• Investment alternatives
• Cash flows reinvested at the MARR at the end of the study period
• Replace with another asset, with possibly different cash flows, after
the study period
The useful life of an alternative is greater than the study period.

• Truncate the alternative at the end of the study period, using an

estimated market value.

• The underlying principle in all such analysis is to compare the

MEAs in a decision situation over the same study (analysis)

period.
 Equivalent worth methods can be used for MEAs with unequal lives.

• If repeatability can be assumed, the MEAs are most easily compared by

finding the annual worth (AW) of each alternative over its own useful

life, and recommending the one having the most economical value.

• For co-termination, use any equivalent worth method using the cash

flows available for the study period.

We can use incremental rate of return analysis on MEAs with unequal lives.
• Equate the MEAs annual worths (AW) over their respective lives.
A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6

Solving, we find i*=26%, so Alt B is preferred.

 Cont…
1. Assume an engineering company borrows $100,000 at 10% per year compound interest
and will pay the principal and all the interest after 3 years. Compute
a. simple and
b. compound interest and
c. total amounts owed.
2. What is the future value of an investment of 200 for three months at a simple interest of
6.5 %?. Specify the interest earned.
3. If you deposit $4500 at 5% annual interest compounded quarterly, how much money
will be in the account after 10 years?
4. If you deposit $4000 into an account paying 9% annual interest compounded monthly,
how long until there is $10000 in the account?